Soon after Josh and I met, I asked him to read “Rich Dad, Poor Dad” (man this guy humors me, I know I’m a lucky girl). After understanding the difference between assets (purchases that generate cash in the long term) and liabilities (purchases that take away cash in the long term), he was on board with buying assets that would create cash flow.
So, we made a plan to invest in real estate. We bought our first home with a no money down VA loan, with the plan for it to become a rental property. That went well.
Then, we bought our first attending house. Our plan got derailed a bit when we realized the negative compounding and huge monthly cash flow hit of my student loans. We decided to pay them off quickly and are SO thankful we were able to do so. To pay my loans off, we sold our larger house and downsized to rent a smaller place. Then, once the loans were paid off, last year we bought an attending house once more. But, this time we had room in our budget to maintain our desired savings rate to invest and build assets.
So, this year, we were back on track to buy our next rental property. In fact, we just closed on a great property yesterday!
Closing day!
In the next few posts, I’ll take you through our rental property hunting saga, one decision at a time.
Please understand that I don’t consider myself a real estate investing guru. I’m simply sharing my thought processes here with you in the hopes that it is helpful to you.
Buying Real Estate in Cash or by Using Leverage
So getting back to our story, first, we did a cash-out refinance on our existing rental property, taking advantage of favorable rates and appreciation. Then, we had to decide whether we would buy the next property in cash or finance it with a new mortgage, leveraging further.
Leverage is the use of debt to amplify returns from an investment, according to Investopedia.
"Hold up, aren't you The Frugal Physician? Hater of all things debt?" I know, I know, it seems counterintuitive, but read on.
Buying in Cash
We were prepared to buy a property in the $150-200k range in cash. We liked this idea for several reasons.
First was our general debt averse stance. We didn’t want to take on more debt.
Plus, without debt servicing costs, monthly cash flow is quite good.
The negatives of buying in cash were that at that price range, we could only buy a single family rental in the current market. So, we would be putting all of our eggs in one basket, with one tenant. If that tenant didn’t pay, the property would become cash flow negative.
Buying Using Leverage
If we took out a mortgage, we could use our cash funds to buy more units, thus dispersing the risk of non paying tenants over several units.
And, we could get a higher return for our money (see below).
I should also mention the tax benefits of using leverage– being able to take a greater depreciation for more properties and being able to deduct mortgage interest.
Assumptions
Image from calculator.net/rentalpropertycalculator
Glossary of Terms:
Capitalization Rate (Cap Rate) = Net operating income (NOI) / Price. A picture-in-time indicator of the rental potential of a property. Good for comparing properties.
Net Operating Income (NOI) = Gross operating income – Operating expenses. Money left over from income after all monthly expenses are taken care of.
Cash on Cash Return (CoC)= Gains or losses associated with ongoing cash flows over time, taking mortgage into account. COC return should increase with time as rents go up and mortgage payments stay the same.
Internal Rate of Return (IRR)= Annualized rate of return for each dollar invested. Useful for comparing returns to other types of investments.
A Hypothetical Example
For example, if we bought a $150k property bringing in $1500/month in rent with cash, we’d have a first year’s cash on cash return of 5.54%, IRR (Internal Rate of Return) of 8.2%, cap rate of 5.73%, and cash flow of $715.83. An aggregate Cash on cash return at in 20 years would be 209.72%.
Image from calculator.net/rentalpropertycalculator
If we bought the same property with a mortgage with 25% down and 3.5% interest rate, we’d have a first year’s cash on cash return of 6.24%, higher IRR of 14.36%, cap rate of 5.73%, but a lower cash flow of $210. But, a cumulative cash on cash return in 20 years would be 659.83%.
Image from calculator.net/rentalpropertycalculator
Keep in mind, if we used leverage, we’d be able to buy not just one $150k property but 4 properties (150k being 25% of $600,000) each bringing in monthly income.
(The returns in this example aren’t great. The property we bought has an IRR of 18%, cap rate of 8, and COC first year of 12%).
The Heart of the Matter
Josh and I thought long and hard about this. First, we had to differentiate investing in an asset from buying a liability. We wouldn’t be buying a depreciating car with borrowed money, we’d be buying an investment that would bring in income (hopefully) and pay for itself.
Once we did that, we asked ourselves, are we looking for a safe investment (cash) with a higher monthly cash flow or a higher rate of return on our money in the long term while taking more risk (mortgage)? We decided to go with the latter.
Yup, we decided to use leverage (yup DEBT) to buy our next property.
Dun Dun Dun. lol. Yeah but really, not all that shocking. I’ll refer you to this post.
In other words, the decision for us was much like choosing our stock and bond allocation. Since Josh and I are both young in our mid 30’s and are still working, we are more interested in a higher return for invested cash, rather than higher monthly cash flow now.
Of course, with leverage comes risk. We take the risk of markets declining and the property being worthless in the future. Or rents declining and not covering the costs of the property.
But, we’re willing to take the risk since we do have alternative sources of income to help us make it through rough spots and transient adverse market conditions.
What do you think? Do you prefer buying investment properties with cash or with leverage?
Stay frugal, y’all!
Disha
Standard Disclaimer: For entertainment purposes only. Not meant to be individualized financial or medical advice. Always run your own numbers or consult a professional before making major financial decisions.